Stock in Lieu of Cash?
Scenario: “I started a social media Web site for people who share an interest in certain niche collectibles. I want people to contribute articles and other content to my site, but I’ve spent all of my money on developing the site and don’t have any left to pay people. I am thinking about setting aside 20 percent of my company — I’m a limited liability company — and giving pieces of that to people who contribute articles or otherwise help me build this site. I’m also planning to raise venture capital for my site down the road when it starts generating interest from advertisers and strategic partners. What is the right way to reward contributors?”
This is a perennial problem for startup businesses of any kind. If someone is willing to work for something other than cash, it’s very tempting to give them a tiny sliver of your company. That’s a temptation you should resist at all costs. When you’re first starting out in business, cash is expensive and stock is cheap. As the business grows, your stock’s value grows until it becomes more valuable than cash. Remember the secretaries at Microsoft Corp. who all became millionaires when the company went public? Here are some reasons not to give out stock to strangers:
(1) Once you give someone a piece of your company, however tiny, that someone becomes your business partner for legal and tax purposes. You will have to send that person IRS Form K-1 at the end of each calendar year showing what their little piece is worth and report that person as a partner on IRS Form 1065 (the partnership tax return) your L.L.C. will have to file each April 15.
(2) Giving someone a piece of the pie doesn’t guarantee they will continue to contribute to your business. You want to give people an incentive to contribute regularly over the long term, not just write a few articles and then sit back and wait for their reward.
(3) Once someone owns a piece of your company, the only way you can legally get rid of them is to repurchase their piece for a price they are willing to accept. If your company is growing very rapidly, they will be inclined not to “sell out” until their share becomes too expensive for you to buy back.
(4) Venture capitalists and other professional investors really, really don’t like it when there are lots of little business partners running around who aren’t making a daily contribution to your business’ growth. They will tell you to get rid of them (i.e., buy them out) before they will consider making a serious investment.
(5) Even if a venture capitalist is willing to tolerate these partners, remember that you’ve legally given away 20 percent of your company. That means if the venture capitalist wants 51 percent of your company (a not uncommon situation) in return for their investment, you now own only 29 percent of the business you founded. Still not bad for a fast-growing technology business, but a lot less than it should be for the 24/7/365 of your time you’ve invested in building it.
So how do you compensate people without paying out precious cash or giving away too much of your company? Here are some suggestions:
(1) Don’t make any offer of compensation at all. Instead, let them tell you what they want in return for their contribution. Even if they ask for compensation, they probably will ask for much less than you are willing to pay.
(2) If that doesn’t work, give them a “founder’s discount” on products, services and subscriptions they buy from your Web site.
(3) If that doesn’t work, give them an “option” to buy a small piece of your company at a future time if you are satisfied with their contribution. It doesn’t have to be a fixed date. You can allow them to exercise their option “when our internal Web pages featuring your content account for 5 percent or more of the total hits on our Web site.” That way, the person will get their reward only if they become a “player” on your site.
(4) If you absolutely must give someone a piece of your business to get them to contribute highly valuable content that will help you grow your business, be sure they sign an agreement giving you the absolute right to buy back their share for a small price within the next five years if they stop contributing content to your Web site for a significant period of time, they contribute content to a competing Web site or you are required to pull their content off of your Web site for any reason.